Beruflich Dokumente
Kultur Dokumente
Contents
1 LIBOR and LIBOR based instruments 1
1.1 Forward rate agreements . . . . . . . . . . . . . . . . . . . . . . 2
1.2 LIBOR futures . . . . . . . . . . . . . . . . . . . . . . . . . . . 3
1.3 Swaps . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3
1
2 Interest Rate & Credit Models
London time. These fixings are calculated from quotes provided by a number of
participating banks. LIBOR is not a risk free rate, but it is close to it: the partici-
pating banks have high credit ratings.
LIBOR is offered in ten major currencies: GBP, USD, EUR, JPY, CHF, CAD,
AUD, DKK, SED, and NZD. Throughout this course we shall assume a single
currency, namely the USD.
In the USD, LIBOR applies to deposits that begin two business days from the
current date (this is called the spot date) and whose maturity is on an anniversary
date (say, 3 months) of that settlement date. Determining the anniversary date
follows two rules:
(a) If the anniversary date is not a business day, move forward to the next busi-
ness day, except if this takes you over a calendar month end, in which case
you move back to the last business day. This rule is known as modified fol-
lowing business day convention.
(b) If the settlement date is the last business day of a calendar month, all an-
niversary dates are last business days of their calendar months.
In addition to spot transactions, there are a variety of vanilla LIBOR based in-
struments actively trading both on exchanges and over the counter: LIBOR futures,
forward rate agreements. The markets for LIBOR based instruments are among the
world’s largest financial markets. The significance of these instruments is that:
(a) They allow portfolio managers and other financial professionals effectively
hedge their interest rates exposure.
(b) One can use them to synthetically create desired future cash flows and thus
effectively manage assets versus liabilities.
(c) They allow market participants easily express their views on future levels of
interest rates.
following business day convention as the LIBOR. FRAs are quoted in terms of the
annualized forward interest rate applied to the accrual period of the transaction.
100 × (1 − R) .
Consequently, Eurodollar futures quotes are linear in interest rates, unlike LIBOR
deposits, FRAs, and swaps (described below) which are non-linear (“convex”) in
interest rates. We shall return to this point in Lecture 3.
At any time, 44 Eurodollar contracts are listed:
• 40 quarterly contracts maturing on the third Wednesday of the months March,
June, September, and December over the next 10 years. Of these contracts,
only the first 20 are liquid, the open interest in the remaining 20 being min-
imal. Their maturity dates are the 3 month anniversary dates of these value
dates. As it happens, the third Wednesday of a month has the convenient
characteristic that it is never a New York or London holiday and its anniver-
sary dates are always good business days.
• 4 serial contracts maturing on the third Wednesday of the nearest four months
not covered by the above quarterly contracts. Of these 4 contracts, typically
the first two are liquid.
1.3 Swaps
A (fixed for floating) swap is an OTC transaction in which two counterparties agree
to exchange periodic interest payments on a prespecified notional amount. One
counterparty (the fixed payer) agrees to pay periodically the other counterparty (the
fixed receiver) a fixed coupon (say, 5.35% per annum) in exchange for receiving
periodic LIBOR applied to the same notional.
Spot starting swaps based on LIBOR begin on a start date 2 business days
from the current date and mature and pay interest on anniversary dates that use the
4 Interest Rate & Credit Models
same modified following business day conventions as the LIBOR index. Interest
is usually computed on an act/360 day basis on the floating side of the swap and
on 30/360 day basis in the fixed side of the pay. Typically, fixed payment dates
(“coupon dates”) are semiannual (every 6 months), and floating payment dates are
quarterly (every 3 months) to correspond to a 3 month LIBOR. In addition to spot
starting swaps, forward starting swaps are routinely traded. In a forward starting
swap, the first accrual period can be any business day beyond spot. Swaps (spot
and forward starting) are quoted in terms of the fixed coupon.
(a) Discount factors, which allow one to calculate present value of money re-
ceived in the future.
(b) Forward rates, which allow one to make assumptions as to the future levels
of rates.
The forward price P (t, T ) is also called the (forward) discount factor for maturity
T and value date t.
Two important facts about discount factors are1 :
(a)
P (t, T ) < 1, (2)
i.e. the value of a dollar in the future is less than the its value now.
(b)
∂P (t, T )
< 0, (3)
∂T
which means that the future value of a dollar decreases as the payment date
gets pushed further away.
This equation is merely the definition of f (t), and expresses the discount factor as
the result of continuous discounting of the value of a dollar between the value and
maturity dates.
Conversely, the instantaneous forward rate can be computed from the discount
factor:
1 ∂P (t, T ) ¯¯
f (t) = − T =t
P (t, T ) ∂T
(5)
∂ ¯
=− log P (t, T ) ¯T =t .
∂T
1
In some markets, these properties are known to have been violated.
6 Interest Rate & Credit Models
The forward rate F (t, T ) for the time t and maturity T is defined as the (an-
nual) interest rate on a FRA starting at t and ending at T . This is the pre-agreed
fixed interest rate on a FRA contract. In order to compute it, let δ denote the day
count factor for the period spanned by the FRA. Then,
1
P (t, T ) = ,
1 + δF (t, T )
and thus
µ ¶
1 1
F (t, T ) = −1
δP (t, T )
µ Z T ¶ (6)
1
= exp f (s) ds − 1 .
δ t
Econometric studies of historical rates data show that forward rates are poor
predictors of future interest rates. Rather, they reflect the evolving current consen-
sus market sentiment about the future levels of rates. Their true economic signif-
icance lies in the fact that a variety of instruments whose values derive from the
levels of forward rates (such as swaps) can be liquidly traded and used to hedge
against adverse future levels of rates.
where C is the coupon rate, P (0, Tj ) are the discount factors, and αj are the day
count fractions applying to each semi-annual period (the number of days based on
a 30/360 day count divided by 360). It is useful to write this formula as
where
n
X fixed
L= αj P (0, Tj ) , (9)
j=1
where
Lj = F (Tj−1 , Tj )
µ ¶
1 1 (11)
= −1
δj P (Tj−1 , Tj )
is the 3 month LIBOR forward rate for settlement at Tj−1 , P (0, Tj ) (here T0 = 0)
is the discount factor and δj is the day count fraction applying to each quarterly
period (the number of days based on a act/360 day count divided by 360).
An important fact about swap valuation is that
where Tmat denotes the maturity of the swap. This equation, stated as
expresses the fact that a spot settled floating rate bond, paying LIBOR and repaying
the principal at maturity, is always valued at par2 . The proof of (12) is straightfor-
ward:
n
Xfloat
PVfloating = δj Lj P (0, Tj )
j=1
n
Xfloat µ ¶
1
= − 1 P (0, Tj )
P (Tj−1 , Tj )
j=1
n
Xfloat
= 1 − P (0, Tnfloat ) .
The PV of a swap is the difference between the PVs of the fixed and floating
legs (in this order!):
PVswap = PVfixed − PVfloating .
2
This is not strictly true once LIBOR has been fixed, as in a seasoned swap.
8 Interest Rate & Credit Models
PVfixed = PVfloating .
It means that the forward swap rate is given by the same expression as the spot
swap rate with the discount factors replaced by the forward discount factors!
(b) As a function T → P (0, T ). This is called the discount curve (or zero
coupon curve).
(c) As a collection of spot starting swap rates for all tenors. This is called the
par swap curve.
The curve construction should be based on the prices of liquidly traded bench-
mark securities. As this set of securities is incomplete, we need a robust and
efficient method involving interpolation and, if necessary, extrapolation. These
benchmark instruments include deposit rates, Eurodollar futures and a number of
benchmark swaps. Benchmark swaps are typically spot starting, and have maturi-
ties from 1 year to 40 years and share the same set of coupon dates. For example,
one could use the following set of instruments:
(a) Overnight, 1 week, 2 week, 1 month, 2 month, and 3 month deposit rates.
(c) Spot starting swaps with maturities 2, 3, 4, 5, 7, 10, 12, 15, 20, 25, and 30
years.
P (0, Tj ) , j = 1, . . . , N, (18)
That does not really solve the problem yet, because we are now faced with the issue
of computing the forward rates for non-standard settlements T (say, a 3 month
10 Interest Rate & Credit Models
Tj − T T − Tj−1
P (0, T ) = P (0, Tj−1 ) + P (0, Tj ) ,
Tj − Tj−1 Tj − Tj−1
for Tj−1 ≤ T ≤ Tj .
Tj − T T − Tj−1
log P (0, T ) = log P (0, Tj−1 ) + log P (0, Tj ) ,
Tj − Tj−1 Tj − Tj−1
for Tj−1 ≤ T ≤ Tj .
1
fj = − log P (Tj−1 , Tj ) ,
Tj − Tj−1
RT
for all j, and we can now easily carry out the integration t f (s) ds in the
definition of P (t, T ) with arbitrary t and T .
(d) Linear instantaneous forward rate. Instantaneous forward rates are assumed
linear between the benchmark maturities and continuous throughout. This is
a refinement of scheme (c) which requires matching the values of the instan-
taneous rate at the benchmark maturities.
(e) Quadratic instantaneous forward rate. Instantaneous forward rates are as-
sumed quadratic between the benchmark maturities and continuously once
differentiable throughout. This is a further refinement of scheme (c) which
requires matching the values and the first derivatives of the instantaneous
rate at the benchmark maturities.
How do we determine the discount factors (18) for the standard maturities?
This usually proceeds in three steps:
Lecture 1 11
(a) Build the short end (approximately, the first 3 months) of the curve using
LIBOR deposit rates and, possibly, some Eurodollar futures3 . This step will
involve some interpolation.
(b) Build the intermediate (somewhere between 3 months and 5 years) part of
the curve using the (convexity-adjusted) Eurodollar futures. The starting
date for the first future has its discount rate set by interpolation from the
already built short end of the curve. With the addition of each consecutive
future contract to the curve the discount factor for its starting date is either
(a) interpolated from the existing curve if it starts earlier than the end date of
the last contract, or (b) extrapolated from the end date of the previous future.
Any of the interpolation schemes described above can be used.
(c) Build the long end of the curve using swap rates as par coupon rates. Observe
first that for a swap of maturity Tmat we can calculate the discount factor
P (0, Tmat ) in terms of the discount factors to the earlier coupon dates:
P
1 − S (Tmat ) n−1
j=1 αj P (0, Tj )
P (0, Tmat ) = .
1 + αn S (Tmat )
We begin by interpolating the discount factors for coupon dates that fall
within the previously built segment of the curve, and continue by inductively
applying the above formula. The problem is, of course, that we do not have
market data for swaps with maturities falling on all standard dates (bench-
mark swaps have typically maturities 2 years, 3 years, 4 years, 5 years,...)
and interpolation is again necessary to deal with the intermediate dates.
With regard to step (c) above we should mention that it is not a good idea to linearly
interpolate par swap rates of different maturities (say, interpolate the 10 year rate
and the 30 year rate in order to compute the 19 year rate). A better approach is to
use one of the instantaneous forward rate interpolation schemes.
(3)
and let Bk (t) ≡ Bk (t), k = −3, −2, . . . , be the k-the basis function correspond-
ing to these knot points. We represent f (t) as a linear combination of the basis
functions:
N
X +4
f (t) = fk Bk (t) . (19)
k=−3
Note that, in this representation, the discount factors are simple functions of the
fk ’s: Ã N +4 !
X
P (t, T ) = exp − γk (t, T ) fk , (20)
k=−3
where λ is a non-negative constant. The second term on the right hand side of
(3.2) is a Tikhonov regularizer, and its purpose is to penalize the “wiggliness” of
Lecture 1 13
f (t) at the expense of the accuracy of the fit. Its magnitude is determined by the
magnitude of λ: the bigger the value of λ, the smoother the instantaneous forward
rate at the expense of the fit. One may choose to refine the Tikhonov regularizer by
replacing it with
Z Tmax
λ (t) f 00 (t)2 dt,
T0
(a) Simplicity, bootstrapping does not require using optimization algorithms, all
calculations are essentially done in closed form.
(b) Calculated swap rates fit exactly the benchmark swap rates.
(c) It is difficult to fit the short end of the curve where many instruments with
overlapping tenors exist.
The list of pros and cons for the smoothing B-splines fitting method includes:
(b) Calculated swap rates are very close, but typically not equal, to the bench-
mark swap rates.
(c) There is no issue with overlapping tenors on instruments in the short end.
14 Interest Rate & Credit Models
(b) Let C0 denote the current forward curve (the “base scenario”). Choose a
number of new micro scenarios
C1 , . . . , Cp
by perturbing a segment of C0 . For example, C1 could result from C0 by
shifting the first 3 month segment down by 1 bp.
We then compute the sensitivities of the portfolio and the hedging portfolio under
these curve shifts:
(a) The vector δΠ of portfolio’s sensitivities under these scenarios is
δi Π = Π (Ci ) − Π (C0 ) , i = 1, . . . , p,
where by Π (Ci ) we denote the value of the portfolio given the shifted for-
ward curve Ci .
(b) The matrix δB of sensitivities of the hedging instruments to these scenarios
is
δi Bj = Bj (Ci ) − Bj (C0 ) .
To avoid accidental colinearities between its rows or columns, one should
always use more scenario than hedging instruments.
Finally, we translate the risk of the portfolio to the vector of hedge ratios with
respect to the instruments in the hedging portfolio.
• The vector ∆ of hedge ratios is calculated by minimizing
1 1
L (∆) = kδB ∆ − δΠk2 + λkQ ∆k2 .
2 2
Here, λ is an appropriately chosen small smoothness parameter (similar to
the Tikhonov regularizer!), and Q is the smoothing operator (say, the identity
matrix). Explicitly,
¡ ¢−1
∆ = (δB)t δB + λQt Q (δB)t δΠ,
where the superscript t denotes matrix transposition.
One can think of the component ∆j as the sensitivity of the portfolio to the hedging
instrument Bj . This method of calculating portfolio sensitivities is called the ridge
regression method. It is very robust, and allows one to view the portfolio risk in a
flexible way. One can use it together with both curve building techniques described
above.
16 Interest Rate & Credit Models
(a) f (t) is piecewise polynomial of degree d. That means that one can parti-
tion the real line into non-overlapping intervals such that, on each of these
intervals, f (t) is a polynomial of degree d.
(b) f (t) has d − 1 continuous derivatives. That means that the polynomials
mentioned above are glued together in a maximally smooth way.
Splines of low degree (such as d = 3, in which case they are called cubic splines)
provide a convenient and robust framework for data interpolation.
A particular type of splines are B-splines. A B-spline of degree d ≥ 0 is a
function f (t) of the form
∞
X (d)
f (t) = fk Bk (t) , (23)
k=−∞
n o
(d)
where Bk (t) is a family of basis functions defined as follows. We choose a
sequence of knot points:
and set (
(0) 1, if tk ≤ t < tk+1 .
Bk (t) = (25)
0, otherwise.
We then define recursively:
and
(d)
Bk (t) = 0, (28)
Lecture 1 17
and thus
Z b Z b Z a
(d) (d) (d)
Bk (τ ) dτ = Bk (τ ) dτ − Bk (τ ) dτ. (32)
a −∞ −∞
Owing to these recursive properties, B-splines can be easily and robustly imple-
mented in computer code.
References
[1] de Boor, C.: A Practical Guide to Splines, Springer Verlag (1978).
[2] Hull, J.: Options, Futures and Other Derivatives Prentice Hall (2005).
[3] James, J., and Webber, N.: Interest Rate Modelling, Wiley (2000).
[4] Press, W. H., Flannery, B. P., Teukolsky, S. A., and Vetterling, V. T.: Nu-
merical Recipes in C: The Art of Scientific Computing, Cambridge University
Press (1992).